As lawyers, we see it all the time: a successful business which generates a good income for the owners or the owners’ family reaches a stage in which the founders wish to either sell the company to outsiders and retire or at least cut back and let others, the “new owners,” take over the running of the business. Such takeover is intended to eliminate, at least in the minds of the founders, most of the risk and turmoil inherent in being the owner. Equally common, the founders of the company hope to sell or give the company to younger members of the family or to favorite employees who have put in years of effort within the company.
And while such goals are certainly logical and understandable, the sad fact is that the majority of founders end up receiving only a fraction of what they thought the company was worth or, even more troubling, having to reenter the company and try to save it from the results of the poor management of previously valued employees or relatives.
A wag once stated that the two most dangerous times for a company are the first two years of its existence and the first two years after it is sold to the next owners. Like so many sayings, there is a large element of truth in it. The complex requirements of a successful transfer of ownership to new owners are quite often overlooked by inexperienced new owners and the old owners, thinking that upon executing the sales agreement they are no longer “on the hook” often neglect to understand that the transferring of responsibility is perhaps the most difficult business task that they will ever undertake.
There are essentially two types of purchase to be discussed in this series of articles. The first type of purchase is the sale of control to employees of the company who are often also family members. This type of sale will be discussed in this article. The second article will discuss sales to outside parties.
Assuming sale to a family member is contemplated, before reading this article the reader is advised to read the three articles on this website relating to The Family Business. Those articles consider issues involving the training and integration of family members into an ongoing business, the methods of transferring stock to the next generation while maintaining some safe guards, and the problems confronted with unhappy reactions by non-family members of the business.
This article shall move beyond such family considerations to the more general issues and problems confronting the owner of a business who seeks to sell ownership to employees already working within the company. It shall not discuss the unique tax issues that may be faced by Employee Stock Ownership Plans and the like but, instead, will concentrate on the questions of how to achieve a successful transition at maximum price yet which minimizes danger to the company while transferring power and responsibility. Clearly close consultation with both an experienced attorney and accountant is vital for the success of any such endeavor: this article merely gives an outline of the issues to be confronted and possible solutions.
WHY SELL TO INSIDERS? THE PLUSSES.
1. No one can know a business like someone who has worked there. The day to day problems, the details of how to resolve them, the personalities of other employees and vendors, the “tricks” of the trade developed by the past owners: all these are things best known by an employee who long worked in the company. Assuming the company was successful in the past, many of the tools that made it successful should be known by existing key employees.
2. Good relationships between vendors and customers may already be established by the buying employee and thus the transition may be improved significantly.
3. Loyalty of other employees to the new owners may be greater than if a large outside company or a competitor suddenly becomes the new boss.
4. Loyalty of the new owners to the prior owners may be maximized and the alienation of old management that is so commonplace when an outside larger company takes over is possibly avoided. The danger of ill feeling and lack of trust may also be avoided since quite often the new employee-owner is also a friend.
5. The old owner may also have spent years slowly grooming the new owners for taking over the position, integrating them into various roles and areas of knowledge that the old owner might not bother to do with an competitor or outside buyer. The old owner is often willing to continue the training and consulting, with or without pay, as the months or even years go by due to his or her mentor role.
6. Complex tax planning to the benefit of both buyer and seller may be arranged due to the close relationship and trust. Such tools as a continuing consulting relationship with various fringe benefits may be arranged which a larger outside company would be unable to provide.
7. The old name and ethos of the company is likely to be maintained if the employees take over and not lost, as so often occurs when a larger outside entity purchases the company. This can be important to an owner who takes pride in the business he or she created and, indeed, may be one of the key values of the company which a larger outside entity may ignore or squander.
8. Key employees may be kept and encouraged by a long process of gradual increasing ownership and the “consideration” for the purchase may be not only the monies exchanging hands for the sale, but the long years of loyalty shown by the employee(s) who otherwise would have been likely to move to another company or start their own.
9. Loss of key employees after the sale is also avoided. It is common for a sale to an outside company to result in the wholesale flight of the very employees who made the company successful. Assuming a good business relationship existed between the new owners and their previous co-employees, such abandonment is more easily avoided.
10. Brokerage fees to business brokers who find outside buyers may be avoided since one finds one’s own buyers and these fees can be substantial…often amounting to over ten percent of the purchase price.
11. The new owners may be more inclined to bring an old owner back in to advise on unique problems thus increasing the chances for solving them. Large companies, with their complex internal political problems, are often too arrogant or bound in Byzantine maneuvers to be able to simply ask the prior owner how he or she would have solved the problem confronted.
12. Above all, there is a deep satisfaction that many owners have in passing the torch to the prior employees who they have worked with for many years. As one selling owner told the author, “I don’t mind taking less money if Jim is the buyer. He and I built that company together and I like the idea of him keeping it going after I am gone.”
WHY NOT SELL TO INSIDERS? THE DISADVANTAGES.
1. The range of possible buyers is sunk to the few employees who may have the skill and desire to purchase the company. Inevitably, this small group of potential buyers lowers the possible price since competition among buyers is restricted.
2. The likelihood of cash buyout is largely eliminated since, unlike a outside larger company or competitor, you are normally dealing with employees who had little chance to accumulate cash resources and quite often the seller will have to largely finance the purchase. These leads to additional problems as to security for the purchase discussed below.
3. Unlike a competitor or an outside company, the new buyer is not an owner with extensive experience in being a boss but, instead, an employee who now seeks to enlarge his or her expertise. But being a boss and responsible for the entire operations of the company is a much different skill than being an employee or head of a department, no matter how intelligent or dedicated the employee buyer may be. Even years of training by the prior owner is into the same as having the control and responsibility that a boss has and the buyer is inherently taking a greater chance in selling to the employee, not only due to lack of experience as a “boss” but in probably having to act as the founder of much of the sale, as discussed above.
4. The new owner may have problems establishing credibility with key employees, vendors, and customers. Often the old owners had created a long term relationship that is not easily transferred to a younger owner with a much different personality. Age can have a definite effect: customers in their fifties or sixties may find it difficult relating to a new owner in his thirties.
5. The new owner may become too dependent on the advice and guidance of the old boss. The old “boss-key employee” relationship may be so comfortable that the new owner unconsciously slips into the same relationship despite the desire (and perhaps the need) for the past owner to retire.
6. Being a key employee is very different than being a boss. This is too often overlooked by owners who assume that the skills for a top administrator or salesperson are somehow necessarily related to the skills of a chief executive. There is no reason to necessarily assume that a key employee has either the skill, the drive, or the determination to become the chief executive officer of a company and simply because your key employee wishes to buy in does not mean that the key employee is going to be able to operate the company effectively.
7. A different but perhaps more common problem is that the old owner feels betrayed by new methods and procedures adopted by the new, younger owner and feels that years of establishing a business and reputation have been ignored or jettisoned foolishly by the new relatively inexperienced owners. This, in turn, can lead to ill feeling and even the destruction of long valued relationships which, in turn, if the old owner is funding the company, can create a dangerous situation indeed.
8. If the business is sold to more than one former key employee, there can easily develop jealousies and differences between them that the prior control of a single prior owner kept under control or hidden. This is now often termed the “Yugoslav Problem,” referring to the collapse of Yugoslavia into warring factions and states once the overarching power of Marshall Tito was eliminated.
KEY DANGER: HOW TO FUND THE BUY OUT
Perhaps the most common issue confronting such a sale is how the employee is to pay for the company. While it is expected that an outside purchaser or competitor will find its own way to pay for the purchase, most employees require that the old owners “take back” paper and help fund the purchase.
Such sales can be secured by various means. All too often the stock in the company is the only security provided. The contract of sale provides that if an installment payment is not made, the stock reverts to the prior owner. The problem is obvious: the installment was not paid precisely because the company is losing money and if it is losing money, the stock securing the sale is probably greatly reduced in value or perhaps worthless. This writer has seen many examples of owners reclaiming ownership due to failure to pay…only to find the company so damaged by new management and customers so alienated that they must either spend years seeking to rebuild the company to its prior level or may even have to close its doors.
Clearly additional security is vital for the safety of the selling owners, and that security may be in the form of deeds of trusts or mortgages on homes of the buyers, the right to control various aspects of the business, and safeguards that allow the owner to quickly regain control if the business falters in certain ways. (Typically, if gross sales or profits fall below a certain level or if expenses rise above a certain level as a percentage of operating cash flow.
But the sad fact remains that by the time reentry is achieved the business would have already suffered (by definition) thus the economic security of the old owners remains locked into thee economic success of the company. As pointed out at the beginning of this article, a primary reason for the sale to begin with is to remove the burden of economic security being locked into the business. As one experienced seller once told this writer, “If I am going to risk my finances on the health of a business, I might as well keep owning it and getting all the profits. This is all risk and no upside.”
Indeed, the main reason people refuse to sell to existing employees is their lack of adequate funds to buy out the Seller. Ultimately, if there are outside buyers, no matter how big and nasty, who can entirely buy out for cash a Seller, most Sellers will opt for that method, assuaging their feelings that they are “abandoning” the employees by perhaps paying out some bonuses to key employees from the proceeds of the sale.
Or, as one Seller told the author, “You want to know why I am selling to Scott? Scott who doesn’t have enough money to buy a car much less my business? Because he’s the only game in town!”
If such is the case, security is the name of the game: one must obtain Deeds of Trusts on homes, guaranties from as many of the buyers as possible, and create a document that provides for very strict review and control of the operations of the business so long as a large debt is outstanding. Remember, most Sellers will not be paid if bankruptcy is declared since they are often “insiders” thus lower on the schedule of allowed payments than third party creditors such as vendors.
And if there is insufficient security to provide any real outside source of monies if the purchase price installment is not paid, then the Seller may be well advised to simply keep owning the business and reaping the profits since the chance of pulling money out in that manner may be greater than selling to broke key employees.
PREPARING THE GROUND TO INCREASE THE VALUE: YEARS DO MATTER
The best way to assure that the key employee(s) will have both the skills and means to effectuate a purchase and maximize the price you can expect is to plan years in advance. If a key employee knows that in five or ten years he or she will have the chance to buy in IF he or she demonstrates skill and has adequate finances, then it is more likely that a good purchase package will be available. If one is the employer, one must be careful and avoid making commitments that are binding in a court of law, thus losing the flexibility to terminate the employee. Legal advice as to applicable employment law is vital.
But assuming such advice is obtained, the careful preparation years ahead is an excellent test of the ability and discipline of the prospective buyer, assures a loyal employee and can create estate planning benefits for the existing owners. See the article on the Corporate Buy and Sell Agreement.
It also allows the prospective buyer to determine if prospective co owners (and current key employees) are capable of working as bosses and partners. Differences can be worked out with years to test each other out that would lead to total disruption in the more pressurized period of just buying the business.
Lastly, it gives the seller the time to determine if the prospective employee-buyer has the fiscal discipline and commitment necessary to amass sufficient sums to at least fund the down payment. If five or ten years of preparation by the buyer do not result in a substantial down payment being available, the existing owner should hesitate long and hard before selling the business to the employee who has failed to save sufficient sums.
The problem is that far too often years of preparation and careful planning may be made completely useless when a key employee receives an attractive job offer and decides to leave or when a spouse or personal requirement results in relocation of the key employee. One client was almost in despair when a key employee, groomed for ten years to buy in, with plenty of money saved up, was subjected to a ruinous divorce that depleted all of his resources and resulted in him leaving the state. “All that time wasted,” our client moaned, “all those years down the drain.” I pointed out to him that they were far from wasted. He had received good services, had prospered during that time, and, above all, had not faced the catastrophe that such a divorce would have caused to his security if the divorce had occurred after the sale was made.
But a key element to this multi year plan to prepare the buyer is flexibility and a willingness to abandon the plan should the training not take root or the personality of the buyer be incapable of assuming control of the business. It may be deeply disappointing to admit that years of preparation have not resulted in grooming of the buyer; but it will be disastrous if that fact is not recognized and acted upon.
Thus from the very commencement of the process, management must be brutally honest with itself and not let fondness for the key employee or a desire to avoid starting from scratch halt the termination of the experiment. Both the method and the contractual relationship of the parties must allow testing and, if necessary, rejection of the potential buyer.
SETTING THE PRICE AND BUILDING UP VALUE
Most businesses are valued as a multiple of earnings plus book value with perhaps some additions or subtractions made predicated on changes in the market that are obvious. Trends in sales and loyalty and diversity of customers are often important considerations of a potential buyer and that is true whether the buyer is in-house or an outside purchaser.
In a small business net profit is normally minimized for tax reasons (though this may alter under changes in the tax law) thus it is gross sales or net profit after adding back in fringes that are the criteria utilized by the sophisticated buyer. (You may have to educate the unsophisticated buyer as to how to value a close corporation.)
But the use of fringes may at times blind the owner as to the true worth of a company and his or her role within the company. This may operate in two ways: at times the owner will take a substandard pay to keep the net profit up and be shocked when told that the analysis by experts of the value of the company is radically lowered by factoring back in the actual wages that should be paid. One client CEO was central to the success of the company, and if in a large company would have been paid far more than he allowed himself. A typical CEO would have received two hundred thousand a year for his quality and amount of work but he only paid himself sixty five thousand. When valuing the company, he found to his shock that the buyer’s CPA subtracted from the valuation formula 135,000 each year of net profit since, if purchased, the company would be required to pay that much for a replacement CEO. The reverse procedure, of course, would occur if the CEO had overpaid himself.
Equally disturbing to some selling owners is the realization that the business, without their unique skills, is worth far less. Often an owner will have developed a reputation in the field or unique relationships with customers that no one else has a chance of developing or will be a technologist of such skill that he or she can solve problems that no other person is likely to emulate. Large companies evaluating such an entity know they cannot repeat that process without constant access to the selling owner as a consultant and often refuse to buy the company without the selling owner being locked into the structure. It is not uncommon to hear a selling owner plead that he or she has no particular skill or reputation in an effort to convince the buyers that the company will maintain sales and the same quality of operations once he or she leaves.
Or, as one client sadly commented, “My company turned out to consist almost entirely of me. Without me, no one would pay anything for it. With me, there was no point in me selling it since I would be stuck there anyway, only as an employee.”
CONCLUSION: DISENTANGLING YOURSELF FROM THE COMPANY TAKES TIME AND EFFORT
If you are the heart and sole of your company, either plan to work in it forever, plan to take a huge discount if you sell it without you…or plan years ahead of time to reduce your central role, if possible. Your critical role is usually recognized more easily by outside buyers since they use professional evaluators quite often who are used to discounting out of the company the value of a key owner. One reason people often sell to their employees is that the employees may not realize how central to the success of the company their boss is. The truth, unfortunately, only dawns upon them as their sales plummet or as problems once easily solved by the former owner, become recurring and debilitating issues.
Again, time is the key. If one is to decentralize one’s own value to the company, one must begin long, long before the sale is actually accomplished. New sales people or new scientists must be integrated in long before the date when one is no longer on the payroll and careful records must be kept to show buyers that the owner is not responsible for all the sales or all the problem solving.
Of course, such diversification of key positions and roles creates a corresponding danger that such well trained successors will, instead of buying your company, start their own or work for a competitor, and the reader is advised to read those articles on this website relating to Non-competition Contractsas well as the article on Corporate Buy and Sell Agreements to determine what restrictions on competition are and are not possible in California.
Creating maximum value for a buyer, however, whether internal or outside, is going to require the risk of developing a company that can survive without you. The skill of training your own replacement is not one easily mastered by the average business person who has long controlled all aspects of the business and made all the decisions. The temptation to take back the reigns often becomes overwhelming as one sees errors, often costly ones, made by the people one is grooming to take over. Yet, to create the sales value may require precisely this effort and the alternative is to face significant reduction in sales price as the buyers realize that the most important asset of the company…the current owners…may very well kill the company by leaving.
A good test is to slowly but surely remove oneself from more and more operations over a multi year period, closely watching the effect on the company AND keeping track of the increasing independence of the company so that such may be demonstrated to any potential buyer. One seller proudly showed a buyer a ticket for a trip to Europe that he had taken two years before the business was offered for sale in which the seller had been abroad for four months without significant change in performance of the company.
But be ready to learn a bitter sweet lesson: that you ARE so critical to the company that it must be severely discounted by your sale and removal from its operations. In some ways that may be satisfying to your ego…but the cost may well be a discounted sales price or even the impossibility of selling the company at all.
But to maximize value you must make the attempt and the attempt, if it is to be successful, must begin years before you decide to put the business on the market. Do not be disheartened if it takes two or even four attempts before staff is available that makes you less central to the continued operation of the company or if a buyer insists that you remain as consultant for a year or more.
And do not be surprised that if you ignore this article, make no preparations for sale, when you find that when you are seeking to sell the company the response you hear is that there really is no company to sell without your active and continuous involvement!